9/24/2008 @ 4:00PM

Market Mess? Blame Your Brain

Eight years ago a handful of brain scientists began using MRI scanners, psychological tests and an emerging understanding of brain anatomy to try and overturn traditional economic theories that assume people always act rationally when it comes to financial decisions. To understand the market, these researchers said, you needed to get inside peoples’ heads. They called their new field neuroeconomics.

If proof was needed that markets can be unpredictable, irrational and cruel, the past few weeks provided it. Bear Stearns and
Merrill Lynch
have been swallowed up by emergency mergers. The government has bailed out
Fannie Mae
,
Freddie Mac
and
AIG
. Lehman Brothers is bankrupt.

So, can these neuroeconomists shed any light on what went wrong? Surprisingly, yes.

At the core of the market mess are securities that were backed by extremely risky mortgages. The theory was that slicing and dicing mortgages diluted the risk away.

But the ratings agencies were being compensated by issuers of the mortgage-backed securities, and neuroeconomics says that created big problems. “You don’t get mistakes this big based on stupidity alone,” says George Loewenstein of Carnegie Mellon University. “It’s when you combine stupidity and people’s incentives that you get errors of this magnitude.”

Consider this forthcoming research by Loewenstein, Roberto Weber and John Hamman, all of Carnegie Mellon. They organized volunteers into partners. One partner is given $10 and told to split it however he sees fit. On average, the deciding partner keeps $8 and gives away $2.

Then researchers repeat the game. This time, the decider pays an “analyst” to decide how to split the money fairly. The game continues for multiple rounds and the decider can fire the analyst. With this change, the decider gets everything. Paying somebody else to ensure assets are divided fairly actually makes things less fair.

Colin Camerer, an economist at Caltech, blames “diffusion of responsibility” for the problems. His own research identifies another problem: Neither investors nor bankers were likely to be considering worst-case scenarios.

Camerer conducted experiments in which two people engage in a negotiating game on how to split $5. But each time they fail to come to an agreement, the value of the pot drops. The negotiators can check the total value of the money by clicking colored boxes on a computer screen. But only 10% look to see what will happen in the worst case.

To make matters worse, hedge funds were bragging about uncanny returns, making the impossible seem possible. But some studies show that these results may have been inflated by a lack of disclosure, Camerer says. Brain imaging studies show that investors as a whole get more and more used to big returns, and thus take bigger and bigger risks in a bull market–and then the bubble pops and stockholders start selling like mad.

One reason: Investors fear losing more than they look forward to winning. According to a 2007 paper, researchers used MRI scans to watch the brains of people as they decided whether or not to take gambles with a 50/50 risk. Gains caused brains to light up in areas that released dopamine (the chemical boosted by Zoloft and Prozac); losses caused those same areas to decrease. Researchers could predict what people would do based on the size of the increases.

Dread, the anticipation of a loss that is expected to happen, is another powerful force. Emory’s Berns has shown that people differ in how they respond to expected pain. He gave electric shocks to people in an MRI machine, and then gave them the option of either getting an intense shock immediately or a less intense shock later. People whose brains started lighting up in areas associated with pain beforehand were more likely to decide to get the pain over with. They also would have sold stock.

So what’s a regulator to do? One argument against big bailouts is moral hazard–the idea that if you bail the banks out now, future bankers will take even bigger risks. Caltech’s Camerer points out that people are naturally shortsighted. People with health insurance do spend more on care, he says, but people who rent cars don’t get in more accidents, because there are more immediate risks, like bodily harm.

But so far the government’s attempts to quell the risk have just reinforced the idea that something is very wrong. If you tell somebody not to think about white elephants, Loewenstein notes, they will do exactly that.

On the other hand, putting a floor in the market for these mortgage-backed securities, as the government’s plan tried to do, could ease investor panic, says Richard Peterson of MarketPsy Capital, who is trying to put neuroeconomic research to work in a $50 million hedge fund.

“Things are unknowable,” Peterson says. “That is the X factor that is causing the risk aversion to accelerate.”